We are paying the price for the deregulation mania of the 1980s. We can settle for just footing the bill and moving on, or we can pay up but also seize the opportunity to restore a vitally lost balance of power. It would be a criminal mistake just to take the first option.
Until the creed of deregulation took control of the political agenda in the 1980s there was a reasonable balance of power between banks and governments. It was destroyed as the regulatory rule books were torn up. After the new era of deregulated banking too hold, banking altered fundamentally, as did the relationship with governments. Banking took off in a direction that left governments lagging far behind. What happened in the UK was typical of what was going on across the developed world. For a century leading up to the era of deregulation, UK bank balance sheets were equivalent to 50 per cent of UK gross domestic product. But by the time the banking crisis erupted in 2007, total UK bank balance sheets had reached 500% of UK gross domestic product. Banking was simply no longer on a scale of equivalence with government or the rest of the economy.
Banking also went global at a very rapid pace. By the time the crisis broke, the world’s top five banks held 16% of global banking assets. It had been half that just a decade earlier. So not only were the balance sheets looming over the size of national economies, so were the institutions.
In this imbalance of power, governments were in no position to challenge the excesses of the deregulated banks. For one thing, there was a growing dependence on the part of government on the sizeable revenues that were flowing into national coffers as a result of all the increased activity. Revenues based on no real assets were still revenues and they were paying for important public services.
The imbalance of power then struck again when the crash came. Government saw before their eyes the spectre of the biggest ever domino effect in history. As large banking institutions staggered towards collapse, both the scale and the interconnected nature of the institutions made it obvious that if they were all allowed to go down, large parts of the world’s economy were going to go down with them. There was no alternative but to rescue. And so the prospect of history’s biggest ever example of moral hazard came into being.
Now we are already seeing the signs of the next chapter in this imbalance of power. As governments begin to seek ways to claw back some of their painfully expended national and political capital, we hear the inevitable whinging about the imposition of windfall taxes on bonuses. But we also begin to hear bankers arguing that governments should not now seek to restore regulation as that will risk choking off the flow of credit needed to fuel the much-needed economic recovery.
We need to stop and count up the bill so far, before we make any decision about who owes what to whom in the aftermath of this crisis. If we add together the total amount of liquidity pumped into the banking system by governments with the total injections of capital, along with all the debt guarantees, the potential exposures as a result of deposit insurance commitments and the asset purchase schemes, we reach the grand total of $14tr. Or, in other words, an amount equivalent to one quarter of the total annual output of the world’s economy. The bill for this binge is truly mammoth. That’s why it cannot just be a case of pay and move on.
The balance of power must be restored, in a way that allows government to act meaningfully to protect the public interest and which also allows banks to provide the fuel to help propel future economic growth. We must not and cannot let this opportunity to correct this near fatal imbalance of power slip away.
The progressive solution requires six key steps. First, banking regulation in future much operate on the same scale as banking itself. We cannot allow a situation to operate where banks are global in life but local in death – bringing disproportionate burdens to bear on whichever hapless government is obliged to play undertaker to the deceased institution. So if the future is still to contain global banks, they must operate within a globally agreed and globally enforceable system of banking regulation. The work on that has started within the G20, but there are already ominous signs of some governments being tempted to break away from a concordat and forge their own regulatory rules. That temptation must be resisted. It will only reopen the path for the banks to play regulatory arbitrage. So, not only must we establish the basic rules of global banking, we must also establish the appropriate institution to police them.
Within the new rules governing global banking, there need to be clear minimum standards set in terms of capital and liquidity ratios – both of which eroded dramatically in the aftermath of deregulation. There will also need to be new rules on leveraging, and new requirements on banks to support counter-cyclical measures, possibly through an insurance scheme with premiums geared to risk.
Second, we must ensure that in future the failure of one institution will not risk bringing down the whole system. This is not just about addressing size; it is also about addressing governance, structure and interconnectivity. Banks must be obliged to construct firewalls between different parts of their operations. If they want to continue to pursue multiple forms of financial activity and trade in a vast array of different instruments, fine, so long as failure in one area cannot trigger collapse in others.
Third, there must in future be a proper match between risk and responsibility. Low-risk activity should never again be held prisoner by the casino merchants. High-risk activity can be tolerated so long as those taking and funding the risk are those who will take the pain in the event of failure, as well as the gain in the event of success. Safe assets cannot in future be gambled on risky bets. Risk can never again be permitted to spread across the whole balance sheet.
Fourth, the regime for remuneration must be geared to real performance, as opposed to paper performance. Part of this is achieved by having clawback mechanisms, or by making bonus schemes bound into long-term objective performance rather than short-term bottom lines. But it can go wider than that. There is no reason why the corporate tax regime which applies to banks should not also be tied into their remuneration practices. Large bonus payments should trigger large windfall contributions to national treasuries.
Fifth, transaction activity should also contribute to repaying the massive public commitment that has been made to rescue the whole edifice from collapse. If the banks argue it is too risky to demand rapid repayment of capital, for fear of choking off much needed credit lines, then there is no reason at all why we shouldn’t recover it over time through a Tobin tax on transactions.
Finally, we should seek to restore community banking. Mutuality has found it all but impossible to survive in the aggressive world of deregulated commercial finance. But mutuality never ran the risks that the commercial bankers did. The time is right to foster once again banking on that solid ethical principle. The opportunity now also exists to make a dramatic step change in the struggle to end financial exclusion for those on low incomes. The fancy banking of the post-deregulation world froze out those who sought access to simple, low-risk products and limited but affordable credit. This is where banking turned its back on an important social obligation. Community banking is starved of funds for development. As the huge public holdings in the rescued banks are eventually sold off, a share of the proceeds should be set aside to invest in, and thereby transform, community banking. That way the resources can be found, for instance, to ensure a viable credit union in every part of the country.
Banking needs to be reconnected to the real world. If it still wants, or needs to be, it can be big, it can be innovative, it can takes risks, it can offer any prospect for reward it wants – so long as none of this ever again has the potential to impose unjustifiable burdens on those who are not direct participants. The industry cannot be allowed to operate on the basis of ‘I’ll take the risk – but you pick up the tab if it goes wrong.’ The balance of power has to be restored, and the time to do it is now.